Managing taxes can be one of the most complex aspects of estate planning, and a new IRS rule change continues that trend. The rule, published in late March, changes how the step-up basis applies to assets held in an irrevocable trust. If you need help interpreting the IRS rule change or setting up your estate, consider speaking with a financial advisor.
What is a basic step-up?
When someone inherits an asset with unrealized capital gains, the asset’s basis resets or “steps up” to its current market value, erasing any tax liability for previously unrealized capital gains.
For example, if you bought $100,000 worth of stock more than a year ago and sold it now for $250,000, you would pay capital gains tax on the $150,000 profit above the original basis of $100,000. If you inherit those shares, however, your new basis will rise to $250,000, and you’ll only pay taxes if you sell the shares for more than that.
To protect their assets, many people place them in an irrevocable trust, which means they lose all ownership rights to the assets. Instead, the trust becomes the owner of the assets for the benefit of the trust’s beneficiaries.
How Changing IRS Rules Affect Irrevocable Trusts
Previously, the IRS had granted the basis step-up for assets in an irrevocable trust, but the new ruling – Rev. Rul. 2023-2 – the situation changes. Unless the assets are included in the original owner’s (or “grantor”) taxable estate, the basis is not reinstated. To obtain the step-up in basis, the assets of the irrevocable trust must now be included in the taxable estate at the time of the grantor’s death.
This is the bad news.
The good news is that, due to the $12.92 million per person exclusion in 2023 ($25.84 million for married couples), few estates in the United States pay even a portion of the estate tax .
In 2021, 6,158 properties were required to file tax returns, of which only 2,584 (42%) paid any tax. By including the assets of the irrevocable trust in the taxable estate, heirs who are the beneficiaries of the trust will avoid the tax hit and receive the step-up in basis. However, this situation may change for some people in 2026, when the estate tax exemption limit returns to the 2017 amount of $5 million, adjusted for inflation.
Why would anyone use an irrevocable trust? A typical reason is to remove assets you own in order to qualify for Medicaid nursing home assistance. A parent could place a home worth $500,000 into the trust, qualify for Medicaid but, include the home in their taxable estate, then pass the property to their children tax-free on a $500,000 basis.
Bottom line
Anyone using an irrevocable trust should review their estate plan to ensure it complies with the updated IRS rule and preserve the step-up in basis for assets that the trust will pass on to their heirs. Building a sufficient estate plan is also something that most people should try to put in place to limit problems for their family in the future.
Financial planning tips
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A financial advisor can help you make sense of important rule changes so your financial plan stays on track. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can interview your advisors at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you reach your financial goals, start now.
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Life insurance can play a vital role in the financial planning process so that your loved ones are protected in case something happens to you. SmartAsset has a life insurance tool specifically designed to help you determine the coverage you need.
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